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Drachma damage control

May 22 2012 07:28

Reuters

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WHEN eurozone policymakers are asked if there is a Plan B to
cope with a Greek exit from the single currency, their typical answer goes
something like this: "There's no such plan. If there were, it would leak,
investors would panic and the exit scenario would gather unstoppable
momentum."

Maybe there really is no plan. Or maybe policymakers are
just doing a good job of keeping their mouths shut. Hopefully it is the latter
because, since Greece's election, the chances of Athens quitting the euro have
shot up.

And unless the rest of the eurozone is well prepared, the
knock-on effect will be devastating.

The Greeks have lost their stomach for austerity and the
rest of the eurozone has lost its patience with Athens' broken promises. But
unless one side blinks, Greece will be out of the single currency and any
deposits left in Greek banks will be converted from euros into cut-price
drachmas.

People outside Greece may think this is simply a Greek
problem. Would it really be much worse than Athens' debt restructuring earlier
this year which passed off with barely a murmur?

But the process of bringing back the drachma is likely to
involve temporarily shutting banks and imposing capital controls. That would
set a frightening precedent.

Politicians and central bankers would, of course, argue that
Greece was a not a precedent but a one-off. But why trust them?

When Greece was first bailed out in 2010, policymakers said
it was a special case. Then Ireland and Portugal required official bailouts,
while both Spain and Italy have had to be helped by the European Central Bank
(ECB).

If savers in Greece get hammered, depositors and investors
in these other weak euro members would want to move their money to somewhere
safer. Fears would rise of a complete breakup of the eurozone.

Indeed, there already has been significant capital flight
from peripheral economies. The best way of seeing this is by looking at
so-called Target 2 imbalances – the amount of money that national central banks
in the eurozone owe to the ECB or are owed by it.

These imbalances are a rough proxy for capital flight.

Four eurozone central banks – in Germany, the Netherlands,
Luxembourg and Finland – have positive balances. At the end of April, the
Bundesbank was owed €644bn, according to data collected by Germany's Ifo
Institute.

The sum has been rising by an average of €33bn a month since
the crisis took a turn for the worse at the end of July last year. Meanwhile,
all the peripheral countries have big liabilities. Italy and Spain have the
largest with €279bn (as of April) and €276bn (as of March) respectively.

A Greek exit from the euro would, at least temporarily,
accelerate capital flight. Measures would need to be taken to counteract it –
to protect both depositors and governments in vulnerable countries.

Fortunately, it's not too difficult to construct a
contingency plan. To protect depositors, the ECB would have to make clear that
a limitless supply of liquidity with very few strings attached was available
for banks across the eurozone.

This would avoid the possibility that savers would find they
couldn't get money out of their accounts. After a while, calm might return.

To protect governments, the ECB would also need to wade into
action. Although it cannot lend to states directly, it can buy their bonds on
the secondary market. Indeed, it has already done so.

It would, though, need to be prepared to buy bonds in
limitless quantities. Otherwise, investors might just run anyway and take the
ECB's money while it lasted.

Although the ECB would have to play the main role in
preventing a panic, the eurozone’s so-called firewall should play a subsidiary
role. The region will soon have two main bailout funds – the existing European
Financial Stability Facility and the European Stability Mechanism.

These could be deployed in two ways.

First, they could provide a backstop to national deposit
guarantee funds. That way, an Italian saver would know that, if Rome's own
guarantee scheme ran out of money, there were funds in another kitty to fill the
hole.

Second, the bailout funds could lend cash directly to
governments that were no longer able to issue bonds in the markets.

However, the bailout funds are not large enough to stem a
panic on their own. They only have €740bn available. Even with help from the
International Monetary Fund, they would not be able to douse the flames.

Although it is fairly easy to think of a plan B, that
doesn't mean it would be easy to get political agreement for it from Germany
and the other creditor countries. One concern would be that the ECB would be
taking huge financial risks by buying government bonds and lending to banks.

Another is that such rescues, which would amount to a big
step towards fiscal union, would take the pressure off the peripheral
governments and their banks to reform themselves and improve their solvency.

On the other hand, failure to act as a lender of last resort
in a Greek-exit panic could trigger a domino effect of bankruptcies – of banks
and governments – throughout the periphery. The euro couldn't survive that.

Germany may soon need to decide between going all-in to save
the single currency or witnessing its destruction.

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